A Case for an Index Futures in Nigeria
This is my second article on a series of cases on how to improve the capital markets especially the equity oriented markets in Nigeria. My first case dealt with an appeal to create another Index, which is float adjusted, that will run parallel to the current plain vanilla total market cap weighted Index. This article can be read here...A case for a free-float-adjusted market capitalization index.
Futures are exchange traded derivative instruments whose values are dependent on an underlying asset. Complex futures have been created in developed markets to help hedge against diverse exposure to risk ranging from simple equity prices to abstract conditions like weather. I will not go into details of how futures work but I will illustrate with a quick example of how it works and how it can be applied when I present the case for this instrument.
Nigeria, as a frontier economy is ripe for a futures market, especially with the recent influx of investment professionals from developed countries. A lot of foreign investors have shown interest in investing in Sub-saharan economies like Nigeria and Kenya but they have been slow in bringing funds because of the low levels of liquidity. The market trades an average of about $12 million a day and a transaction of a mere $20 million, which is a fraction of major funds, can throw the whole market into a tailspin for days. There are also several funds that are not allowed to invest directly in developing economies because of several risk factors but they are allowed to have exposure through indirect investments like exchange traded funds, global depository receipts and futures.
A futures market in Nigeria can have only one instrument to start with, the float adjusted NSE Index or even the current Index, with varying times to expiration ranging from thirty days to one year. Futures are generally very liquid instruments with very little transaction costs relative to the notional invested value. The Index futures can thus provide an avenue for foreign portfolio managers to gain exposure to the growing Nigerian economy without the fear of liquidity. This will also enhance portfolio diversification and alpha portability for those with investment policies that restrict direct portfolio investment in developing economies. Futures will also provide an avenue for those who believe the market will trend down to take a short position that will provide gains when the Index goes down. Once the index futures is successful other securities can be gradually introduced into the futures market and liquidity will be enhanced on hitherto illiquid securities as the futures market begins to act as an agent of price discovery.
The complex interaction of all these factors will help accelerate the ongoing capital market reforms as regulators are forced to lean towards global best practices. Investors interest in the Nigerian market will explode as they are encouraged to switch from futures exposure to portfolio investments and then to direct investments, the last being a more stable form of capital inflow.
A quick illustration of the index futures. The NSE Index closed today at 24,765.60 and the current one year treasury bill, which is the risk free rate, is 6%. Assuming a market dividend yield of 4%, the one year futures that will expire on December 30, 2011 will be priced at 25,265.90. (The complex futures pricing calculation using the 365-day convention has been left out.) An investor who believes that the market will go up may decide to buy (or go long) the one year futures contract while another party who believes the market will go down will take the opposite end, thus selling (or going short) the contract. At the initiation of the contract, no fund will exchange hands but each party will have to deposit some amount of money that will be determined by the futures exchange that will be used to cover for the daily marking to market. Assuming the market goes up tomorrow by 1.0% to close at 25,013.26, the futures price will move up to 25,517.13. The investor who bought the contract would have made N251.23, indicating a return of 0.99%; this return is slightly different from the Index return. The N251.23 will be deducted from the short's account and deposited into the long's account at the end of the day in a mark to market process. Any of the investors can sell their positions to any interested party at anytime.
In conclusion, I will reiterate that the Nigerian market is ripe for a futures exchange and I hope this will come to fruition before the end of 2011.